Where You Stand Depends on Where You Sit…

I am talking about the rules that China does and doesn’t play by. China has developed an alternative to Western style democratic capitalism. Call it authoritarian capitalism if you will. China does not feel that it has to adapt and accept the standards from the West. It is developing its own viable, and it thinks, better model.

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Part of this model calls for the country to be world competitive if not dominating in ten high tech industries. This “Made in China 2025” is an admirable goal if it were not for the fact, as Mr. Trump and many critics argue, that China steals some of the technology involved here, forces companies who want to do business in China to disclose state-of-the-art technology and favors state led companies over foreign ones in procurement.

President Trump is calling China out on these moves. China has always been willing to make temporary changes to their buying and selling patterns to satisfy the U.S. but they have not been willing to make any systemic changes. Perhaps the only way to require them to do this is by brute force, restricting the sale of sensitive technology to Huawei for instance.

Knowing President Trump and his tweets, this all might be resolved amicably tomorrow, who knows, but the fact remains that China is a fast rising #2 with all the intention of being #1, and this power struggle with the U.S. will continue for a long time.

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We risk today the danger of creating a two or three system model for the global economy, a system for China, a system for the U.S. and maybe a third system for Europe. This means perhaps different standards for 5G, different standards for PCs and smartphones and whole different platforms for social media. It will throw sand in the gears of global growth. The outcome is very much unclear, certainly above my pay grade right now. What will a Balkanization of the global economy look like? Will the world’s supply chain shift from China and if so to where? Back to higher cost U.S. or to Mexico, Vietnam, Malaysia, etc.? Will we see consumer nationalism develop, with the Chinese buying Huawei while we buy Apple? Lots of questions, few answers.


What Should We Be Doing Now?…

There is a general level of unease in the stock market today. Investors are not panicking but everyone is wondering, how long can this stock market rally continue? As the chart at the bottom shows, this current Bull Market is the longest in history. A big shoe has got to be about to fall or so goes one line of thinking.

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The quote from Warren Buffett to the right is spot on. You can teach investors all you want but when they get scared, they get scared. Peter L. Bernstein who died in 2009 reminded us about our ‘memory banks,’ those collective experiences we have lived through and which control our thinking about the future. We remember the Crash of 2008-2009 and the next one has to be equally painful or so says the human behavior side of our brain.

So how do we handicap the timing and severity of the next decline? Well we can turn to experts. We feel comfortable with experts, they speak authoritatively. But relying on experts may be the worst thing to do. Atlantic magazine in its June issue examined the record of experts. The National Research Council Committee on American-Soviet Relations has been running a test of expert forecasting about foreign affairs for thirty years. They have accumulated over 82,000 prognostications about the future.

They found that experts were horrific forecasters whether they were doing this over a short-term period or long-term. Experts get blinded by the narrowness of their knowledge and the inability to see the bigger picture. Better to practice ‘beginner’s mind;’ be open to many ideas and avoid the preconceptions of experts. Don’t underestimate the ability of laymen to make sense of this world. As Bob Dylan wrote, “you don’t need a weatherman to know which way the wind blows”.

If we can’t turn to experts then how about turning to what the market is saying? Here also there are problems. The Harris Reputation poll measures how people rate companies, highly rated or lowly rated. You would think that highly regarded companies would outperform more lowly regarded ones. Actually the reverse is true. The lowly regarded companies outperform. The reason is that highly regarded ones already sell at a high price reflecting their reputation. Low reputation stocks have very little expectation built into their price.

We are Value investors and believe in the idea that investors do not like to be associated with losers. They sell stocks with poor prospects down to levels even lower than they ought to be. A positive turn of events can boost Value stock prices significantly.

We don’t know when the next decline will come. Age alone does not end a Bull Market. Be careful not to abandon your long-term strategy out of fear of a short-term decline. In addition, protect yourself by finding generally successful companies selling at unusually low valuations. And finally, look further afield and consider international markets where valuations are lower than here in the U.S. In these uncertain times it is important to read the financial news but equally important, to read the tea leaves of your own emotions and behavior.

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Is The U.S. Overdue For a Recession?...

I will do my best economist impersonation here and answer - yes and no. The yes part has to do with age. This recovery is nearly ten years old and if we keep going past July, as we almost certainly will, it will be the longest recovery in history.

But age alone does not kill expansions. Economic excesses and unexpected curve balls out of left field do. This recovery has not been excessive; it has been slow and steady. The average annual growth the past decade has been 2.3% versus 3.6% per year in the 1990s. There are no easily identifiable bubbles today. Interest rates are still low, inflation is benign and the housing market, although much improved since 2009, is not at nosebleed levels.

The Federal Reserve has shifted to neutral on interest rates. Unless inflation gets out of hand, rates will be held steady. And what about inflation? I have always been attracted to the relationship between wage increases and productivity. If you give someone a wage increase but their productivity (how many widgets they produce in an hour) goes up by an equal amount then there is no need for companies to increase prices to maintain profit margins, and inflation stays quiet. A nice balance.

Unit labor cost is the name they give to the difference between wage increases and productivity. Historically there has been a positive correlation between unit labor costs and inflation; when one goes up the other goes up, and vice versa. Over the past eight years (see chart below) unit labor costs and inflation have on average moved very much in unison.

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How do unit labor costs look going forward? Productivity has been naggingly slow in this recovery. Nobody knows exactly why, maybe it’s because it takes time for new technology to become effective or maybe it’s because, as some critics charge, all this new technology (social media?) doesn’t do much to increase production.

But productivity is on the rise right now. Over the past three months productivity has jumped 3.6% and over the past year, it is up 2.4%. This is a refreshing switch from slow gains in the recent past (again, see chart). Right now unemployment is very low and we should expect companies to increase wages faster in the future to lure good hires. But if productivity also increases at a faster rate, then we are in a wonderful sweet spot, with no need for prices (or inflation) to go up rapidly.

I realize I am still avoiding the question, what about the next recession? Right now, US economic fundamentals are signaling the recovery will continue. But the wildcard is all the unexpected events like continued China/U.S. trade friction or a sharp downturn in consumer confidence. I am positive on the economy today though I have all fingers crossed due to the many uncertainties.


The All China Edition…

I spent the month of March in China, travelling from the deep south to the mid section of Shanghai/Hangzhou/Zhoushan. My economic thoughts are detailed on pages 2 and 3, my reflections on culture and life on page 4. And here is my ‘Lonely Planet Guide’ to the not-miss sights.

1. Wherever you go use the ‘Gaotie’, China’s high-speed trains. They are clean, new and arrive to the minute on schedule. Oh, and did I mention they all go 150-180 mph. Air travel is a hassle whether in the US or China. High-speed trains are comfortable, you get a front row view of the scenery and they are cheap. Shenzhen in the south to Beijing in the north is a 1500 mile trip costing $140.

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2. Climb a mountain. If you want to experience a living, breathing Chinese landscape painting climb the most famous Chinese mountain, Huangshan (Yellow Mountain) about 3 hours from Shanghai (picture above). You can climb the thousands of knee jarring steps to one of the summits or, more conveniently, take a cable car up. Either way the view and the experience is spectacular.

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3. Shanghai is a not miss city. But how do you see a city of 25 million? A great option is the $18 sightseeing bus which circles the major sites. Yes its touristy but a leisurely way to see the highlights. Another option is the modern, cheap, easy to use subway system. Choose a stop, look around and then get back on. Don’t miss the Shanghai Museum. A world class collection of landscape paintings, ceramics, furniture and jade. A real treasure. And finally don’t forget the food. Food follows money as the saying goes and China has money today. A signature dish of Shanghai is ‘Xiaolong Bao’ or soup dumplings (pictured above). These delicate dumplings are filled with pork and injected with soup. Be careful when biting in however, the soup can be hot but the taste is divine.

4. If Shanghai is a bit too bustling for you, take the high-speed train an hour west and you get to Hangzhou and Suzhou. The West Lake in Hangzhou is a gem, an enormous lake with islands, pagodas, temples - - everything you imagine classical China to be. Suzhou is famous for its delicate gardens including the ‘Humble Administrator’s Garden’, which of course begs the question, where does a ‘humble administrator’ get the funds for such a lavish garden? In any case, enjoy the trip - the going is still good.